Wednesday, February 4, 2009

China's Economic Frankenstein

China's economic planners are trying to create an economic Frankenstein by combining half-understood classical economic concepts with central planning. Will they succeed in creating the perfect economy? Or will their monster run out of control and destroy itself and its creator?

This week, China's State Council released another in a 5-year succession of "No. 1 Documents" to show its resolve to address lagging rural incomes. This year's document emphasizes a regional layout plan to concentrate different types of agricultural production in the regions best suited for them. There are 16 major commodities and 58 regions. For example, areas in Inner Mongolia and Heilongjiang have been designated as dairy regions; areas in Henan have been designated for beef. The southern coastal area of Guangdong has been designated as the region to produce aquaculture products for export.

The plan is an example of China's hybrid approach to economic development that combines economic concepts with government planning. The Layout plan is supposedly based on the principle of comparative advantage. Government planners decide which regions have a comparative advantage in rice, hogs, beef, etc. and set out to develop the best-suited industries in each region.

Comparative advantage, as explained by classical economists David Ricardo and Adam Smith, is the principle that regions can gain by specializing in the activity they produce at least cost and trading with each other. The comparative advantage principle is advanced to argue that free trade can make everyone better off. China is using comparative advantage to guide government planning.

China is a country run by engineers who think they can plan the economy and make it run like a machine. The problem is, planners are not omniscient and often make mistakes. Chinese planners have built up industries with remarkable speed. They have in many cases gone too fast, with dire consequences. Arguably, the "export-oriented" aquaculture industry was built too fast. Crowded, dirty fish ponds were treated with antibiotics, supply chains weren't ready to handle a big volumes, and U.S. farmers and fishermen were undercut by cheap products. A flood of citric acid and other corn-based products coming from big factories linked to corn industry development plans have flooded markets in North America and Europe, driving down prices. Northeast China is swimming in surplus corn while Chinese buyers snap up soybeans overseas at a blistering pace.

Central planning failed everywhere it was tried during the "scientific" hubris of the 20th century. The Chinese planners haven't learned that yet and it may take some time, as long as they have the option of exporting their excess capacity.